1Q2021 Market Perspective: How the Economic Recovery Impacts

1Q | 2021 Market Perspective How the Economic Recovery Impacts Markets, Inflation and Productivity

What a Difference a Year Makes. Index, returned 54.6% over the last twelve months, and 4.6% over

In 2020, we were in the early stages of a global economic the last three months. More encouraging is the markets have shutdown to slow the spread of COVID-19. Global equity markets broadened out. It is no longer a large-cap growth story. The equal tumbled during March and governments around the world moved weighted S&P 500 has outperformed the capitalization-weighted to supply both fiscal stimulus to assist those out of work, and index by over 5% year-to-date, and by over 15% for the last twelve monetary stimulus to support liquidity in the fixed income markets. months! This broadening of performance is also seen in the value/ growth dynamic as value has outperformed growth this quarter by After Easter Weekend, it is beginning to feel that we are on approximately 10% as measure by the Russell 1000 indices. the brink of a new dawn. Vaccines are being administered, and economies are beginning to positively respond as more people are The return of economic growth is positive for the equity markets, vaccinated. Unemployment rates are coming down, though still though it has been accompanied by increased volatility in the well above pre-pandemic levels, while fiscal and monetary stimulus fixed income markets. This has been especially evident in the remain. As a result, the financial markets are anticipating improved U.S. market given the extent of both monetary and fiscal stimulus. growth and earnings. Long-term Treasuries have declined almost 16% for the last twelve months, with most of the decline occurring this past Equity markets have recovered from the depths of last March; the quarter (-13.5%). global equity market, as measured by the MSCI All Country World

APRIL 1Q 2021 YieldYield Spread –– 10yr10yr vs vs 3mo 3mo

500 Spread Between 10yr and 3mo Bill 400

300

200 BPS

100

-100 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20

Source: FactSet

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How the Economic Recovery Impacts Markets, Inflation and Productivity

Prospects for Higher and Lower Inflation regained in a subsequent recovery. As a result, the Fed recognizes

Investors are now faced with determining whether the increase in that the risk around a 2% inflation target is not symmetrical and yields is due to the cyclical improvement in economic expectations, the risk of undershooting the target is greater than overshooting or whether given the global stimulus (particularly in the U.S.) is for a period of time. foreshadowing an environment of significantly higher inflation. The table below shows how the Fed has performed over time in

We will analyze the U.S. environment as a proxy for the global hitting its inflation target. The Fed, despite periods of significant inflation outlook among the key currency markets: Dollar, monetary stimulus, has consistently undershot it’s 2% inflation Euro and Yen. target with the exception of the early 1990’s. This suggests that there continues to be deflationary forces in the global economy. The Federal Reserve recognizes that over long periods monetary policy cannot affect output and employment, but that it can control One doesn’t have to look far to see these forces in action, the level of inflation and therefore the volatility of output. This particularly in the technology companies that increase consumer means the Fed’s optimal policy is to target a desired level pricing power: Amazon, Uber, Airbnb, and VRBO, to name a few. of inflation. In addition, we have written about the drivers that can cause

Furthermore, the Fed has stated why it is targeting a level of lower economic growth. These factors include decreases in both 2% inflation over time: “Over time a higher inflation rate would the labor force and productivity that are both growing slower since reduce the public’s ability to make accurate economic and financial 2000 than we have witnessed in previous decades. These forces decisions. On the other hand, a lower inflation rate would be have produced two conditions. First, the long run, neutral real associated with an elevated probability of falling into deflation… rate of interest has declined. Estimates put this rate at about 1%, a phenomena associated with very weak economic conditions. a decrease from over 2% just a few years ago. Also, the normal Having at least a small level of inflation makes it less likely that the growth rate is closer to 2% rather than the historical 3.5%. With economy will experience harmful deflation if economic conditions current interest rates at near 0%, all these factors limit the Fed’s weaken.” ability to prevent a recession.

Recent research also has suggested that the case for minimizing As a result of these factors, we expect the Fed will look to error on any possibility of a recession is magnified because there is no the side of more inflation rather than less. Since consumer prices reason to expect that the output lost in a recession is subsequently have increased at rates lower than their objective, there is room for an “overshoot.” While we do expect to see an increase in inflation in the short-term, as global economies recover from the pandemic, we do not expect a long-term increase in inflation. Furthermore, Inflation Undershot Fed Target central banks worldwide have developed tools following the 1970’s inflationary environment to control inflation. The world PERIOD INFLATION RATE has been in a disinflationary environment for over 40 years. Now From 1990 to Present 1.90% that economies have reached low levels of inflation, it is unclear From 2000 to Present 1.72% whether the central banks, working in isolation, can increase From 2010 to Present 1.60% the rate of inflation. We suspect fiscal policies will be required to Source: FactSet support long-term growth.

The securities identified and described do not represent all of the securities purchased, sold or recommended for CUIT Funds, CBIS Global Funds and separate managed accounts. The reader should not assume that an investment in the securities identified was or will be profitable.

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How the Economic Recovery Impacts Markets, Inflation and Productivity

APRIL 1Q 2021

Fed DevelopedDeveloped Tools Tools to to Combat Combat Inflation Inflation

11.00 10.00 9.00 8.00 Disinflationary Monetary Policy 7.00 Guns and Butter 6.00 plus OPEC Shock 5.00 4.00 3.00 Disinflationary Headwinds? 2.00 Percent Change from a Year Ago Year a from Change Percent 1.00 0.00 1970 1980 1990 2000 2010 2020

Source:Source: U.S. U.S. Bureau Bureau of Economicof Economic Analysis Analysis

The Importance of Infrastructure Spending governments. Many of these infrastructure investments result in

Regarding fiscal policy, we are beginning to see signs of policies a monopoly. After all, once an airport is built, the marginal cost of moving away from short-term support stemming from the impact another airplane taking off or landing is minimal, while the upfront of COVID-19 to more meaningful investment programs, particularly cost of constructing a new airport provides a barrier to entry for a in the U.S. with President Biden’s administration’s infrastructure profit-seeking entity to build a competing facility. proposals. While not delving into the debate on how to pay A strong public role is therefore required to promote economic for infrastructure investment, we do want to comment on the efficiency. Furthermore, there are infrastructure projects that long-term “return on investment” from infrastructure spending. society has decided should be available to all, such those that Importantly, is an investment in infrastructure an efficient use of provide safe drinking water, sanitation, electricity, etc. taxpayer dollars or should it be left to the private sector? We have highlighted the lower, long-term expected economic First, let us define what we are talking about. Infrastructure growth rates, and how the central banks cannot influence long- investment that is publicly owned is often referred to as the term growth. However, infrastructure investment has been public capital stock1. This capital stock is comprised of the roads, estimated to be a much more efficient fiscal stimulus policy than buildings, bridges, ports, utilities, airports, etc. that are financed by almost any tax cut or spending programs. This is because “the public funds and whose ultimate owners are local, state or federal primary virtue of infrastructure investment as fiscal stimulus is that

1 The Potential Macroeconomic Benefits From Increasing Infrastructure Investment, Economic Policy Institute, July 18, 2017

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How the Economic Recovery Impacts Markets, Inflation and Productivity

it is spent,”2 while, tax cuts and direct transfer payments can be One of the reasons for the high output multiplier is that saved, reducing the stimulative effect of the spending. Also, the infrastructure investment has been shown to have a direct output multiplier from infrastructure investment has been estimated relationship to increases in private productivity. As shown in the to be almost 1.6x. In other words, for every dollar of infrastructure graph below, investment in infrastructure has been in a steady spending, gross domestic product increases by $1.60. Compare this decline since 1949. However, other studies4 have found that any to the multiplier of an across-the-board tax cut of 1.03x.3 economic gains from infrastructure spending increased productivity, while also significantly raised future GDP.

APRIL 1Q 2021 Public Investments in Infrastructure has Never Regained its Earlier Levels What Does This All Mean for Investors? PublicCapital spending Investments on transportation/water in Infrastructure infrastructure has andNever broad Regainedinfrastructure, its measured Earlier as Levels a share of potential GDP, 1949-2015 1. Central banks will maintain low short-term interest rates and maintain a stimulative position until inflation exceeds the 2% target for a period of time. 3.00 2. 10-year U.S. Treasuries would be fairly priced between 2.50 3-4% in this scenario. (At the end of the month, the 10 2.00 year yield was 1.74%)

1.50 3. The implied bond P/E would range between 25-33. Yields Percent have room to move higher before there is a significant 1.00 impact on the equity market. 0.50 4. While there is concern about the level of debt to GDP, 1970 1980 2000 efficient Federal spending, particularly in infrastructure, Infrastructure, broadly Transport/water infrastructure can boost long-term productivity, and GDP. This can enable economies to deleverage their debt levels through growth. Notes: The broad infrastructure series includes public investment in hospital and educational structures, highways, sewers, transportation facilities, and conversation and development. Each series is scaled against measures of potential GDP from CBO 2017.

Notes:Source: The broad Author’s infrastructure analysis of data series from includes the Bureau public of Economicinvestment Analysis in hospital (BEA) fixedand educational structures, highways, sewers, transportation facilities, and conversation and development.asset series Each (Tables series 5.9.5A is scaled and 5.9.5B) against and measures the Congressional of potential Budget GDP Office from CBO 2017. (CBO 2015) Source: Author’s analysis of data from the Bureau of Economic Analysis (BEA) fixed asset series (Tables 5.9.5A and 5.9.5B) and the Congressional Budget Office (CBO 2015)

2 Ibid 3 Zandi, Mark. 2011. “US Macro Outlook: Compromise Boosts Stimulus.” Economy.com (Moody’s Analytics) John W. Geissinger, CFA 4 Bovino, Beth Ann, Oct. 11, 2019, Infrastructure Investment As An Elixir for Ailing U.S. Productivity Growth, S&P Global. (https://www.spglobal.com/_division_assets/imag- Chief Investment Officer, CBIS es/special-editorial/iif-2019/infrastructureinvestment_new.pdf)

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